Start-up taxation

The economic upheaval wrought by Covid and geopolitical tensions with China threaten to disrupt capital flows to one of the few bright spots in the economy — the start-up ecosystem. Consequently, it has become imperative for start-ups to not only tap into new sources of risk capital, but also geographically diversify their funding. The recent report from the Parliamentary Standing Committee on Finance has useful suggestions to address these issues. One, it suggests that investments in unlisted securities be exempted from Long Term Capital Gains (LTCG) tax for a minimum of two years. After this period, it recommends that the Securities Transaction Tax (STT) be levied, instead of LTCG, to ensure parity with listed shares. Two, it flags the disparity in tax treatment between foreign and domestic investors in PE/VC funds, where foreign investors get away with minimal tax incidence by routing their money through low-tax regimes, while domestic investors suffer 20 per cent tax plus surcharge. This anomaly, taken with the GST on management fees, incentivises PE/VC funds to domicile their vehicles offshore. Three, echoing a long-standing demand of the PE/VC industry, it calls for domestic pension funds, banks and insurers to raise their allocations to AIFs.

Two of the three suggestions are worth considering. Investors who bet on the unlisted shares of start-ups take on far higher business and liquidity risks than those in listed shares. Given the gestation periods of start-ups, they are typically more long-term oriented too. There’s, therefore, a good case for the Centre to consider a no-LTCG regime for investors in unlisted securities at least for a limited period. Whether a two-year period would suffice is debatable though, as PE/VC investments usually mature in 5- 7 years. Subjecting unlisted securities to the STT appears to be a convoluted method to restore the status quo. There’s little logic for both the LTCG and STT regimes to co-exist even for listed securities and the STT ought to be done away with. With a lot of start-up funding originating from HNIs, there’s also no reason to restrict the no-LTCG regime to funds alone. The current angel tax regime requires individual investors to jump through far too many hoops to get tax exemptions and needs drastic simplification. Encouraging more PE/VC players to manage their funds out of India by ushering in parity on income tax and GST treatment is welcome too. But the Centre must think twice before acceding to calls for domestic pension funds, insurers and banks to increase their allocations to start-ups, given that many of these institutions are still taking baby steps in listed equities and bonds.

Ultimately, returns and liquidity play a far bigger role than taxation policies in driving investor interest into any new asset class. On this score, the focus should remain on removing bureaucratic impediments that hold back small businesses from scaling up and developing the primary market to facilitate timely exits for venture investors.